Lessons From Real Estate Stocks’ Non-Bounce

Eurozone stocks have rallied alongside US stocks since last autumn’s lows, and their participation in this global bull market is gaining notice—as is one eurozone sector’s notable absence from the party. Real estate stocks initially bounced alongside the rest of the region, but they have since slipped to new lows before mostly skidding sideways. Pundits seem divided on what will come next, which we don’t think is terribly consequential considering the sector is a sliver of the regional and global market. But we do think there are some interesting things to glean, particularly since the sector’s struggles aren’t confined to the eurozone.

US real estate hasn’t floundered as badly as eurozone real estate, but it hasn’t done too well. As Exhibit 1 shows, while it fell more than the S&P 500 during the bear market, it hasn’t enjoyed the outsized rebound typical of the categories that get hit hardest in the downturn. Instead, it has spent long stretches going sideways and remains well behind the S&P 500 since last October’s lows.

Exhibit 1: The Bounce Effect Skips Real Estate

Source: FactSet, as of 7/18/2023. S&P 500 Index and S&P 500 Real Estate total returns, 1/3/2022 – 7/17/2023. Indexed to 100 at 1/3/2022.

We see a couple of things going on here. One—which is a big headwind globally—is higher long-term interest rates. Because REITs are highly leveraged, their returns tend to be interest rate-sensitive. Higher rates mean higher financing costs, reducing profit margins. As Exhibit 2 shows, Real Estate and 10-year Treasury yields had a pretty strong inverse relationship as long rates rose last year and retested prior relative highs late this winter. But the correlation has flipped since the beginning of March, turning slightly positive—rates and Real Estate moved together a bit more often than not. To us, this suggests pretty strongly that stocks have priced in higher long rates. Therefore, hinging a stock market forecast on what you expect rates to do from here seems quite mistaken.

Exhibit 2: Real Estate Stocks Are Getting Over Higher Rates

Source: FactSet, as of 7/18/2023. S&P 500 Real Estate total return and 10-year US Treasury yield (constant maturity), 1/3/2022 – 7/17/2023. Real Estate returns indexed to 100 at 1/3/2022. A correlation of -1.0 means the two variables always move in opposite directions, 0.0 means no relationship, and 1.0 means they always move together.

Two, commercial real estate is a big part of the REIT market, and commercial real estate happens to be one of investors’ biggest fears this year. Due to high office vacancies and regional banks’ large role in this space, refinancing worries hit commercial property hardest. The lethal combination of higher rates, tighter credit and falling rental income, headlines claim, will cause an office building bloodbath that risks rippling through bank balance sheets and the broader economy. Yet given Real Estate’s marked underperformance, it seems hard to argue markets are ignoring this talk, teeing up a surprise later. Rather, it pretty clearly appears to be weighing on sentiment, holding Real Estate stocks back even as long-term interest rates drift lower. Markets, it seems, are pricing in the fear.

So ask yourself: If the broad market is up nicely while Real Estate is struggling amid commercial property angst, what are stocks trying to tell us? Could it be that commercial property might indeed have some refinancing troubles here and there but these aren’t likely to spill over to the broader economy and markets? To us, this is the most logical interpretation of the seeming disconnect. First principles, after all, hold that markets discount all widely known information, including fears, opinions and forecasts. If one sector is languishing while the broad market is up, it doesn’t make sense to argue the market is falsely ignoring a problem in that one sector. No, it usually means the broad market has assessed the impact and moved on. Quite rightly, in our view, considering the relatively small size of the commercial property market. Office REITs are just 0.07% of S&P 500 market capitalization.^[i] Regional banks’ balance sheet exposure is also quite small, as we showed in the spring.

When in doubt, trust the market. If it is signaling that a widely discussed risk isn’t a market-wide problem, we think this is a strong indication that it is high time to get over the fear and move on.